China is a Symptom of a Broken Financial System

This week kicks off where last week finished…it’s all about China. Today, I’ll try to put what’s going on in China into a longer term context.

Over the past week, a lot has been written about the stock market crash in the Middle Kingdom. The important thing to understand is that this is not just about a stock market crash. The volatility is a symptom of a much larger issue.

The ‘much larger issue’ is indeed a big one. It’s about the global financial system coming up against its natural constraints. That doesn’t mean it will cease to exist anytime soon. But it does mean the system’s ongoing existence will continue to create waves of violent volatility.

2016 has certainly begun with a bout of violent volatility. It probably comes close to being the worst start to a year for global markets ever. That’s saying something.

And it’s something you should worry about. That’s especially the case now that there’s been an official statement about the health of China’s financial system. From the Financial Times:

‘China’s financial system is “largely stable and healthy,” the country’s foreign exchange regulator said at the weekend in an effort to reassure global markets as investors braced for a possible resumption of last week’s market turmoil.’

Translated, that means China’s financial system is mostly unstable and unhealthy. If it were otherwise, there would be no need for official statements to the contrary.

So how did things get like this?

Let’s go back a few years. This following is simplified and abbreviated…obviously. But I hope you get the drift of why it has lead to the current day situation.

Back in the early 2000s, the US suffered a recession brought about by the dotcom bust. In response the Fed lowered interest rates sharply. In December 2001 China became a member of the World Trade Organisation, which brought the country into the global trading system.

It also pegged its currency to the US dollar. This is something many smaller emerging market economies do to provide confidence in their currency or financial system. It also locked China into the US dollar based global financial system.

As a result, China produced cheap goods and the US bought them. China recycled the proceeds from their manufacturing gains into US treasury bonds. This helped to keep interest rates low and ensured the US would keep on consuming Chinese goods.

China steadily built up massive foreign exchange reserves due to this form of development. What most people don’t realise about these reserves is that while they sit on the balance sheet of the People’s Bank of China (PBoC) as an asset, there must also be an accompanying liability.

In this case, the liability is the reserves of China’s domestic banking system. So as China’s foreign exchange reserves grew (mostly denominated in US dollars), so did the yuan denominated reserves of its domestic banks. The PBoC had to print yuan to ensure the currency peg remained stable. Those printed yuan ended up as domestic bank reserves.

Why is this important? You’ll see in a moment.

When the crisis of 2008 hit, it threatened to destroy China’s economic model of export driven growth. The authorities had to do something drastic. So they unleashed a massive fiscal stimulus and credit boom. The fuel for the credit boom lay in the banks’ reserves.

This enabled China to grow at breakneck speed. It also set off a property price boom and infrastructure bubble. Australia, and other commodity producers, enjoyed the party immensely.

But China’s credit boom got out of hand. A shadow banking system emerged offering high rates of return on murky investments. These high returns encouraged speculative capital to flow into China. Borrowing cheaply in US dollars to invest in high yielding yuan denominated assets seemed like a no-brainer. After all, the currency peg meant the two currencies were effectively one. Therefore, there was no currency risk.

But in 2013, the Fed hinted that QE would soon end. Chinese markets wobbled, but then steadied. Now with QE over, and interest rates in the US beginning to rise, the no-brainer trade is turning into a disaster.

As I explained on Friday, speculative capital is now fleeing. China’s foreign exchange reserves are shrinking too. That represents a contraction in the domestic banking system. That’s not what you want when fighting a credit bust.

One of China’s only ‘solutions’ is to weaken the currency. But the yuan is still doing better than many of its competitors. After last week’s carnage, it ‘only’ fell 1.6% against the dollar. The Singapore dollar, one of the hardiest currencies in Asia (if not the world) fell 2.4%!

China needs to do devalue properly. But I’m not sure it can without setting off global market panic. I’m not sure where things go from here. No one is. What you’re seeing is the slow crumbling of the US dollar based financial system. The strength of the US dollar is a perverse symptom of this.

The crux of the issue is that the post-1971 financial system is characterised by US Treasury debt building up in the vaults of many central banks around the world. That’s because the US dollar was the world’s ‘reserve asset’.

This ‘asset’ formed the basis for an expansion of credit in these economies. This global credit expansion was all very good for growth.

But that process is now going into reverse. Can the US Federal Reserve check it by doing an about face on interest rates? My guess is that it will try to at some point. You’ll soon see rhetoric start to change about future interest rate rises.

Whether this will have a lasting effect on markets though will be the crucial issue. Or is it already too late to mend a broken system?

Greg Canavan,

For The Daily Reckoning

PS: Picking winning stocks in this type of market is not easy. But my mate, Aussie small-cap specialist Sam Volkering has come up with a way to pick such stocks. He calls them ‘shockproof’. You can check out his presentation here.

Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market.
To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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